How a cost segregation study can focus your fixed asset strategy

Has your business acquired, constructed or substantially improved a building recently? You may want to get a cost segregation study to develop a strategy around capitalizing your fixed assets. It could allow you to accelerate depreciation deductions, to ultimately reduce taxes and increase cash flow.

Tony Constantine, CPA, a tax partner at Ciuni & Panichi, Inc., says, unless you’re in the business of owning real estate, you may not be aware of the benefits of a cost segregation study. In fact, some accountants don’t understand how these studies can provide savings.

“You don’t even have to be the property owner. A major tenant that does a large build-out could take advantage of this if they own the improvements,” he says.

Smart Business spoke with Constantine about cost segregation studies, depreciation and how they apply to your fixed assets.

How can a cost segregation study reduce your company’s taxes?

IRS rules generally allow business owners to depreciate commercial buildings over 39 years. They can depreciate structural components — walls, windows, HVAC systems, elevators, plumbing and wiring — along with the building.

Companies often allocate all or most of a building’s acquisition or construction costs to real property, overlooking opportunities to allocate costs to shorter-lived personal property or land improvements. Personal property, depreciable over five or seven years, can include removable wall and floor coverings, detachable partitions, awnings and canopies, window treatments, signage and decorative lighting. In addition, certain items qualify if they serve a business function. Examples include reinforced flooring to support heavy manufacturing equipment, electrical or plumbing installations, and dedicated cooling systems for server rooms. Land improvements — fences, outdoor lighting and parking lots — are depreciable over 15 years.

A cost segregation study applies engineering methods to quantify the building materials, reconciling that to the purchase price. It uses statutes and case law to determine how items can be depreciated.

What other tools can apply to fixed assets?

The tangible property regulations provide a framework for determining when to capitalize an expense and when to expense it.

Additional incentives amplify the benefits of putting a strategy around your fixed assets. Section 179 allows for an immediate expensing of tangible personal property, such as desks and equipment. That limit was $500,000 in 2017, but under the Tax Cuts and Jobs Act, it jumps to $1 million in 2018.

Another incentive is bonus depreciation, where employers write off a percentage of the cost basis of an asset with the first-year depreciation. Prior to the new tax law, a 50 percent bonus depreciation was available for new property. Now, any asset, new or used, acquired from Sept. 27, 2017, to 2023 can be written off at 100 percent.

What else should business owners know about creating a fixed asset strategy?

Don’t just look at the hypothetical benefit; consider the whole picture. How do you maximize the provisions and use them to get the biggest benefit? You might be in a situation where, depending how the ownership is structured, if you create losses, they’ll be limited. So, paying $10,000 for a study and an extra depreciation deduction doesn’t make sense. Other times, a study might increase cash flow by $50,000 but cost $10,000. Some people will think that’s great and they’ll do it. Others won’t think that’s enough margin to go through the hassle.

Apply a global strategy — not only for this year, but next year and beyond. Your tax adviser can look at your situation, tax rate structure and the provisions that are applicable to see where and when your company gets the biggest benefit. But you also need to provide a clear picture, if you plan to sell an asset in five years, rather than keep it for the full term, that changes the modeling and potential benefits.

If you already invested in depreciable buildings or improvements, it may not be too late to take advantage of a cost segregation study. A ‘look-back’ study allows you to claim missed deductions in qualifying previous tax years. You can also review your depreciation schedule to see if equipment, for example, is in the wrong asset class.

Insights Accounting is brought to you by Ciuni & Panichi, Inc.

Data analytics and AI are the future of internal audit and fraud investigation

Data analytics helps people better understand their business and see weaknesses and inefficiencies more clearly. Analytics can also increase revenue through pricing optimization or analyzing margin or costs to improve the efficiency of the manufacturing process. Many internal audit departments, however, are just getting on board with this trend.

Smart Business spoke with Kirstie Tiernan, data analytics managing director for BDO, Chicago at BDO USA, LLP, about data analytics, especially as it relates to internal audit and why artificial intelligence (AI) adds even more value.

How are employers developing programs around data analytics?

Data analytics requires people, tools, infrastructure and IT, and it’s an involved investment. That’s why it’s best for employers to start developing programs by focusing on one area, such as accounts payable. Once a program analyzes variables like duplicate vendors and payments, employers can expand into accounts receivable, journal entry review, payroll, analyzing customer behavior or pricing optimization. Employers might also benefit from working with an outside vendor, and its tools and subscriptions, so they can evaluate their baseline before purchasing anything.

What are some risks to be aware of?

First, avoid collecting garbage data that requires time and effort to clean. When looking to make better use of data, you should review your information governance policies. How have you collected data? What data are you collecting? How long are you retaining it? Who has access to it? Are you collecting it in a way that you’re able to verify it? It’s critical to have a method to improve the quality, so your analysis is useful in the end. Cybersecurity is a concern as well. Make sure you’re storing data appropriately and that third parties with access to your data are vetted and secure.

One pitfall of data analytics — especially with internal audit — is that people tend to focus on generating reports. They can get overwhelmed and find it hard to wrangle those results into value. As you’re creating your analysis program, make sure you have the results in mind. If you get 5,000 exceptions from an analysis, it’s not a good analysis. You want limited results and as few false positives as possible. That takes upfront planning. The goal is targeted analysis.

The holy grail of analytics is an alert-based program. A restaurant that looks at voided transactions on a monthly basis, for example, might find it more valuable to receive emails flagging where and when voided transactions took place. Those emails can include which voided transactions look fraudulent based on the knowledge of why voided transactions are an issue. This format moves you away from cumbersome report reviewing and toward real-time analysis of specific problems you need to address.

How does AI aid fraud investigations?

Rather than analyzing samples of data, AI incorporates statistical and advanced analytics to review entire populations for anomalies. It’s a new level of analysis that reviews an entire population of data to find transactions that look different. As the advanced algorithms get smarter, looking across more industries and company data examples, they identify anomalies more quickly and efficiently.

If you suspect fraud, targeted data analytics can look for variables like your typical round dollar payments or users with inappropriate access. When you’re unaware of fraud, however, it can be difficult to know where to run specific analytics. This is where AI is invaluable, running millions of data points through algorithms for a quicker focus and narrower scope. Rather than running 50 reports and sampling the results, AI looks at the entire data set. For example, in one investigation, the client had 10 million journal entries over three years of data. It knew it had a fraud issue, but wanted to understand the fraud’s scope and if there were other issues beyond the ones it was aware of. Plus, the client had three days to get back to its auditors. BDO used Mindbridge to examine all 10 million entries. Of the top 10 accounts of highest risk as noted by the tool, two of those accounts had fraud. When you don’t know what you’re looking for or you’re unsure of the scope of the fraud, advanced analytics incorporating AI can provide a quicker and lower-cost application of analytics.

Insights Accounting is brought to you by BDO USA, LLP

Careful due diligence is needed when seeking incentives

Financial incentives provide a competitive advantage to businesses. Local officials understand the importance of attracting new businesses and are willing to provide economic development incentives. But how does an existing business compete for the same attention and financial investment from local leaders?

“While new business attraction grabs the headlines, savvy officials are aware that approximately 80 percent of new jobs are created by existing businesses,” says Graham Allison, president of Graham A. Allison & Associates LLC, an affiliate of Clarus Partners.

He says local officials regularly hold ‘retention and expansion’ visits with companies already in the community to identify their needs and discuss growth opportunities.

However, not all companies seize their chance for help.

“Many of these local businesses invest in new jobs, equipment and infrastructure without determining if they are eligible for incentives, and the opportunity passes them by.”

Smart Business spoke with Allison about the incentives available to companies, when they can be used and what to consider before pursuing them.

In what situations do companies have the leverage to negotiate for incentives?

In general, the larger the investment and the number of jobs created, the greater the likelihood of a more robust incentive package. Companies have the most leverage when there is interstate or international competition for the project and when incentives are a key factor in the decision to expand.

The opportunity for incentives arises from investment in new jobs, equipment, technology, infrastructure, and brick and mortar. Rather than exerting leverage, companies can look to create a public-private partnership in which both the community and company benefit.

What kinds of incentives should be requested?

Discussions around incentives typically refer to municipal or city-level incentives. Yet, there are numerous types of incentives at the local, county, state and federal levels. CEOs should make expansion decisions based on all the information at their disposal.

There is a bit of art and science to negotiating incentives. Each program has its own goals and mission to aid in job creation, along with specific compliance requirements. It’s important that companies avoid asking for an incentive that cannot be utilized.

Who from the company should be represented during incentive negotiations?

This can be done multiple ways — an anonymous site selection project or direct discussion with state, county and local officials by the CEO and his or her team of advisers. It is also helpful for CEOs and CFOs, as well their accountants, to work with incentives specialists who can help maximize the opportunity to gain incentives. Economic development incentive specialists can help save time and effort when determining eligibility for incentives and help drive the negotiation process to positive outcomes.

What can businesses that are looking for incentives do to get what they’re after?

Businesses should do their homework. Most incentive programs have strict, codified covenants that require diligent compliance reporting to avoid claw-back of incentives. It is important to know going into a negotiation if the business will be eligible to receive incentives at all based on the level of investment and jobs created. A consultant can take you down a relevant path.

Financial incentives can have tremendous positive impact to the bottom line. While local officials are generally willing to provide incentives, they are not without strings. Prior to making any major expansion or investment, it is important to know if the cost of gaining incentives justifies the efforts to obtain them. A professional who is well-versed in the process can help to create the most advantageous outcome that is a win-win for communities and the business.

Insights Accounting is brought to you by Clarus Partners

Measure your organization’s security posture to ensure protection

The data companies have in their digital networks multiplies daily. And as the workforce becomes increasingly mobile, more and more devices seek to connect to that data via the internet, creating significant vulnerabilities for companies.

“Too often business leaders don’t understand the nature of the data that’s sitting on their network,” says Joe Compton, a principal at Skoda Minotti Risk Advisory Services. “Companies that fail to do comprehensive risk assessments have no way of understanding the potential business impacts if that data were to be stolen or rendered inaccessible.”

He says that’s why it’s important that organizations adopt an IT security framework (e.g., PCI, HITRUST, NIST sp800, or ISO 27001) to protect sensitive information from those who seek to profit from it illegally.

Smart Business spoke with Compton about what companies should know about the data they keep and how to protect it.

How do businesses determine what security standards to adopt?
Before selecting a security framework, companies should first determine what data they have and where it is, then assign some level of risk to each data category.

Data should be classified by its level of sensitivity. The highest level of security should be assigned to data that would be most damaging to the company or its clients/customers if it were to be captured by a bad actor. Another aspect to data classification is the importance of its availability. What data must a company access daily to operate?

Consider how threats could affect the integrity of data processing. These could alter a transaction or alter the way other information is processed in the system so that it becomes inaccurate — an attack that could affect bank statements or payroll.

Once a company understands the types of data and the risks the loss of each poses, it can select a security framework. Adopting a framework of controls gives the company the ability to audit and test its protections and understand how network threats are being handled. It also provides management a decision framework when considering enhanced security controls.

The simplest control framework to implement is PCI DSS (Payment Card Industry Data Security Standard), which is designed to protect credit card holders against the misuse of their personal information. Adhering to this standard doesn’t guarantee that a company’s data will be secure, but it does offer a sound framework of best practices to reduce unmitigated threats.

How can organizations feel confident that their security is adequate?
Once a company has implemented a security framework, it should conduct security testing to expose flaws. At a basic level, this can be done as automated, weekly vulnerability scans that alert management to discovered weaknesses and advise how they can be remediated. It’s also a good idea to conduct regular penetration testing to ensure systems can’t be altered or otherwise tampered with.

It’s also important that every organization achieves some type of segregation of duties. There should be adequate testing of user roles in the system to make sure users can’t escalate their privileges and access otherwise restricted information.

What is the process to make sure these benchmarks are being met?
It’s critical to conduct regular security and risk assessments, either internally or through an outside provider, and make sure internal logs are being monitored for activity.

If a company has the resources, getting an independent, third-party opinion on a regular basis is always good.

The third-party provider’s job is to identify vulnerabilities and deliver ideas on how to make the environment more secure. Established and reputable third-party providers are likely in hundreds of environments every year, which gives them a broad perspective on the types of threats that exist and how to stop them.

Companies must be diligent when monitoring and testing their networks. If a breach or attack does occur, it’s better to know within 24 hours than six months later. It’s not about perfection, but rather mitigation. That takes a well-defined process and a cohesive plan to manage.

Insights Accounting is brought to you by Skoda Minotti

 

Accountants can help family business owners protect assets after a divorce

Divorce is an unfortunate end to about 2 percent of marriages each year. When the assets of one or both spouses include a family business, the proceedings get more complicated. The value of a closely held business and the owner’s spendable cash flow from the business are two of the more heavily contested matters in divorces.

“It’s not unusual for the spouses to have drastically different ideas on what the business is worth and how much cash it generates,” says Robert Evans, a senior manager at Clarus Partners. “Many times, the non-operating spouse knows little about the finances of the business, but believes it is very profitable and valuable. And in a divorce usually one spouse wants a low value for the business and the other spouse wants a high value.”

Smart Business spoke with Evans about divorce and business valuations and how to find an accountant who can help, rather than hurt the process.

What makes someone the right accountant to deal with a business owner’s divorce?

The right accountant is an expert who holds an accreditation in business valuation such as an Accredited in Business Valuation (ABV) or Certified Valuation Analyst (CVA) from a recognized certification organization. Only about 1 percent of CPAs hold such designations — those who have completed specialized training, met minimum experience requirements, passed examinations and maintain their skills through specialized continuing education.

Valuations prepared by non-accredited accountants that are submitted to a court may be inadmissible.

Once the expertise requirement is satisfied, the next important factor is whether the accountant can simplify the information and present it in a way that non-accountants can understand. A business owner’s time is valuable, and attorneys and trials are expensive. An accountant who can calculate and document a reasonable value, who can then effectively explain to others why that value is reasonable, and who can defend his or her methods and conclusions can go a long way toward agreeing on a value rather than litigating it.

What is the accountant’s responsibility?

The attorney usually hires the accountant. He or she determines the nature of the work needed and gets the approval of the client to retain the expert. Among the several reports and tasks that may be requested by the attorney is a business valuation, which is a formal document that describes the entity and the ownership interest being valued. It also discusses the business’s economic environment as of the valuation date, includes historical and sometimes projected financial statements, analyzes the financial statements in detail, adjusts the financial statements as necessary, and then values the entity. As a part of this process, the owner’s compensation and perks are analyzed and possibly adjusted to a market value.

For some purposes, net book value or a rule of thumb multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) is acceptable, but these are not acceptable methods for a business valuation in a divorce proceeding.

Why is it advisable to bring in a specialist accountant?

Often the family business is the most valuable marital asset. In an attempt to pay legal and accounting fees, equalize the division of property and provide spousal and child support, the attorneys or the court may rely on the family business to provide more than it can reasonably give and potentially harm the business from either a cash flow or a credit standpoint. Companies need cash to purchase assets and to fund growth and may have loan covenants that they must meet. Here’s where the credentials and the communication abilities of the accountant can be used to show how much the business can give and help protect the business.

Sometimes the business is both separate property and martial property. The accountant can work with the attorney to make the necessary calculations to properly allocate the value between separate property and marital property.

Accountants who are experts in divorce can bring clarity to the numbers and help protect business owners and their businesses during a stressful time.

Insights Accounting is brought to you by Clarus Partners

Avoid the pitfalls of payroll compliance for a globally mobile workforce

Taxable expenses paid on an employee’s behalf, such as a company car for personal use or individual tax preparation services, must be reported in payroll even though there’s no cash disbursement. These benefits-in-kind or items of imputed income are challenging to comply with. This is further complicated when employees work internationally and have items paid on their behalf outside of the normal realm of wages and bonuses, says Diane Moore, JD, experienced manager of expatriate tax services at BDO USA, LLP.

“It’s worth having a specialist come in to look at your globally mobile workforce,” Moore says. “We look to see where they’re going, if there’s a treaty, if there’s a recharge and what types of expenses are being paid. Many companies make the mistake of thinking that if an employee spends less than 183 days in a country, there is no tax requirement. That can be a dangerous assumption as it assumes a treaty exists and also does not consider some of the other requirements where a treaty does exist, such as a recharge.

“Once you know your risk, you can decide whether it’s worth it to you to invest in becoming compliant. It’s more expensive when somebody comes to us because they’re under payroll audit and need help cleaning up a mess,” she says.

Smart Business spoke with Moore about the biggest pitfalls of payroll compliance for a globally mobile workforce.

What is a globally mobile workforce?

A globally mobile workforce falls under the umbrella term ‘expatriate,’ which can mean either a U.S. citizen going to work outside the U.S. or an inbound, foreign national coming here to work. They each have different payroll challenges.

How do U.S. citizens going overseas need to be treated for payroll compliance?

When U.S. citizens work internationally, companies often pay for housing, children’s schooling, home leave and individual foreign tax. These must be captured in U.S. payroll. In China, for example, housing paid by an employer is tax-free, but it’s taxable here and needs to be reported on a W-2 Form. The U.S. employer needs that information, but Chinese entities may not be used to gathering it.

When companies cover expenses, W-2 wages will look very high. A lot of that income can be mitigated by the foreign earned income exclusion and foreign tax credits, but Social Security and Medicare are still due on those allowances. That’s why it’s so important to run these items through payroll; employers have a responsibility to withhold and remit those taxes. Otherwise, there is exposure of negligent or fraudulent reporting for the company and individual.

Tax jurisdictions trying to raise revenue have increased scrutiny in this area. Border agents are becoming more empowered to ask specifics of an international entry. If you say business is the reason for your visit and there’s no tax remittance mechanism set up, you could be stopped. There is a global move toward nationalism in many countries that is fueling this.

What are the challenges with foreign employees inbound to the U.S.?

Foreign employees coming into the U.S. may often stay on their home country payroll. However, if they earn more than $600, a Form W-2 needs to be filed. The U.S. entity should run what’s called a shadow payroll, which mirrors all items of compensation or benefits that are paid out of the foreign country and ensures the foreign national’s W-2 is properly reported.

A French national, for example, working in the U.S. might be paid by the French parent company. Income tax gross up has to be calculated as part of the shadow payroll so the French employer pays the required U.S. tax withholding every pay period. Otherwise, when the French national reports their income, the employer is exposed for not properly reporting payroll, which again can be classified as fraudulent reporting.

The initial setup for shadow payrolls and year-end adjustments for U.S. citizens or foreign nationals can be complicated and difficult, but once it’s set up and your employees understand it, it’s easy to keep it going.

Insights Accounting is brought to you by BDO USA, LLP

What the elimination of the throwback rule means for Ohio businesses

Ohio’s recently enacted budget has eliminated the throwback rule, which means that businesses are no longer taxed by the city in which they are located for a sale made outside of their home city. In fact, in most situations, the transaction is not taxed at all.

“The rule change should save Ohio businesses money,” says Larry D. Friedman, CPA, MT, director of taxation at Barnes Wendling CPAs. “However, companies will need to closely monitor sales activities to ensure they’re able to take full advantage of the rule change.”

Smart Business spoke with Friedman about the throwback rule and what its elimination means for businesses.

What is the throwback rule?
The throwback rule, which relates to city income tax, states that if a business ships goods to a customer outside of its home municipality — the municipality in which the business is physically located — the sale is taxed in the business’s home municipality.

The law was designed with municipalities in mind to counter nowhere income, or an income stream that was difficult to attribute for tax purposes. Throwback rules made it so all sales were considered to originate at the factory, as long as the company doesn’t have solicitation somewhere other than where the goods were produced.

What counts as solicitation?
Solicitation is typically considered regular sales visits — at least once per month — or a permanent office. If there is enough activity to qualify as solicitation, the municipality in which the solicitation takes place can, under the current rules, tax the sale. Passive sales, such as when transactions are made through a website, do not qualify to be taxed.

There have been discussions around creating a nexus in one form or another that would act as a presence for tax purposes, but nothing has been settled. For now, the rule relies primarily on physical presence.

What businesses will be affected?
The change affects businesses that sell goods outside of the borders of their home city. It relates only to sales of tangible personal property — service providers are treated differently. Companies that sell goods outside of their primary location and have solicitation in another municipality will continue to have tax obligations in those locations.

There is some relief for companies with solicitation in multiple locations. The state is enacting a centralized option for net-profit municipal filings. Rather than a company filing in multiple locations, a business can choose to file one return with the state, which will process the returns and dole out the income taxes owed to municipalities.

How should affected businesses adjust?
Businesses should pay close attention to where sales occur. They will need to keep a close eye on what their sales people are doing, how often they’re soliciting customers in municipalities outside the company’s hometown, and by what means.

Each municipality has its own tax rate, so how this affects a company comes down to the rates, if any, that now affect it. There will be situations in which transactions are taxed because the company has solicitation. The difference between the rates of those municipalities will determine if there is a net savings or increase.

Generally, however, companies most likely will realize a smaller city income tax burden, less tax overall and more net income.

Are municipalities expected to challenge the change to the throwback rule?
It’s unlikely that municipalities will be happy with the change since it could mean a loss of tax revenue for many of them. It’s hard to say, at the moment, if they’ll police transactions more aggressively or if they’ll press for a legislative solution.

The potential exists for municipalities to undertake more audits on companies to look for unreported or under reported revenue streams to make up the difference. But again, there has not yet been a clear signal that will happen.

The elimination of the throwback rule is another example of Ohio attempting to become more business friendly. For most businesses, this change represents tax relief, but in order to take full advantage of the opportunity, its incumbent on companies to ensure they’re documenting transactions better than they have in the past.

Insights Accounting is brought to you by Barnes Wendling CPAs

How to effectively wrap up your business’ financial year

How well prepared a business is to close out the year varies a great deal from business to business, says Nancy E. Supowit, CPA, MAS, director at Clarus Partners. Some don’t prioritize closing or thinking ahead, while others have procedures in place to ensure that closing and planning take place at appropriate times throughout the year.

Smart Business spoke with Supowit about strategies that help businesses and owners stay on top of their financial health.

What should be the focus for businesses in December?

December is a great time for businesses to check their accounting records and make sure that the books accurately reflect business activity and position. It’s also a time to do preliminary work, review year-to-date records to identify trends and unusual activity, and make corrections if needed.

Year-to-date records are a good reflection of the year’s activity and can be used for decision making and year-end planning. Most businesses aren’t able to finalize everything before the new year since they depend on reports that aren’t available until the following year. However, they can check over their own records and year-to-date reports in December so that when the outside reports arrive, there will be fewer surprises and the final entries can be done quickly.

What happens if a business fails to wrap up its current accounting year?

When businesses don’t close the books on time, the owners can’t read the story of the year’s successes and failures. They might need to rush through a late closing for reporting or tax filing purposes and they might incur higher outside accounting bills to accomplish the task.

Owners also miss out on an important tool for understanding their businesses and for decision-making. If accurate records aren’t available in December, the owners don’t have useful information for tax planning.

What do you suggest businesses do to be better prepared for next year’s year-end planning?

Businesses should consider the following:

  • Make sure accounting records are in good shape. Read the records and consult with an adviser to suggest tax savings strategies.
  • Consider large fixed asset purchases. Businesses can often use accelerated depreciation to reduce taxable income.
  • Set up retirement plans to optimize retirement savings for owners and employees. Keogh plans for self-employed owners have to be set up before Dec. 31.
  • Consider whether the company can qualify for tax credits such as the Research and Development Credit or Work Opportunity Credit.
  • Adjust compensation and year-end bonuses to reflect performance and optimize tax results. This is especially important for owner-employees.
  • Communicate fringe benefit information to payroll departments, including S corporation owner health insurance costs.
  • Check that board meetings and corporate minutes are up to date and revisit big-picture issues such as line of business, choice of entity and succession decisions.

What do business owners need to do at year’s end to wrap up their financial year?

Business owners should meet with their tax advisers in December to discuss their anticipated tax position. They can:

  • Set up retirement plans for self-employed individuals.
  • Optimize security sales to harvest gains or losses depending on the year’s results.
  • Adjust withholding or the fourth tax estimate to avoid April surprises, including the penalty on underpayment of estimated tax.
  • Utilize the annual gift tax exclusion, which is currently $14,000. A married couple can gift another married couple up to $56,000 tax-free.
  • Utilize your wealth to make deductible charitable contributions or contribute to 529 educational plans for family members. There are many ways to optimize charitable giving, including donating appreciated property. The Columbus Foundation and other organizations offer convenient donor-advised funds.

Insights Accounting is brought to you by Clarus Partners

What ASC 606 means for the restaurant industry

The new revenue recognition standard issued in 2014 is finally here. ASC 606: Revenue from Contracts with Customers will affect nearly every company in America — including restaurants.

It replaces multiple pieces of revenue recognition guidance with one overarching principles-based standard that any company in any industry could apply to its revenue transactions, converging for the most part with the international standards.

“One downside is that it’s a one-size-fits-all, which we all know doesn’t always work as well as customized guidance might,” says Angela Newell, national assurance partner with the BDO Dallas office.

In the restaurant space, franchisors are going to feel the change the most.

Smart Business spoke with Newell about the new revenue recognition standard and its impact on restaurants.

What changes will the restaurant space see?

The new standard will result in a significant change in the accounting for upfront franchise fees and area development fees charged by franchisors.

Franchisors typically recognize franchise fees when a franchise opens. Under the new standard, franchisors will likely defer that upfront franchise fee and recognize it over the franchise term, which can be 10 or more years, putting the fee on the balance sheet and amortizing it into revenue over the period. The thought is that the value to the franchisee doesn’t end when the store opens, it continues over the life of that franchise agreement. Going forward, franchisors will report a deferred revenue liability on their balance sheet. This new liability needs to be communicated to stakeholders.

While franchisees and owner/operators aren’t expected to experience the same far-reaching changes, they may have to make changes to the accounting for their gift cards and loyalty programs.

Everyone — franchisees, franchisors and owner/operators — will have to comply with additional footnote disclosures. They need to ensure they have access to the information and then be prepared to report it regularly.

When do the new rules go into effect?

The new standard is effective for calendar year-end public companies on Jan. 1, 2018. Private companies get an extra year. Calendar year-end private companies won’t have to adopt until Jan. 1, 2019.

What should companies do now?

Many restaurant companies, especially smaller private companies, haven’t spent much time on this, because it’s not effective for them until 2019. While restaurants are impacted less than some, the change may be painful because they’re not used to dealing with complicated revenue recognition.

Start by making sure you understand the standard and what it entails for your company. Accounting firms have published short implementation guides that help explain the impact. Even if the standard isn’t effective for you until 2019, plan ahead and, to the extent you can, do a dry run to work the kinks out. If your company uses systems to account for franchise revenues, make sure the system can handle the new accounting rules. No matter how easy it seems, it takes a while to get those changes pushed through an IT system and tested. If you’ve never needed such a system, it may be time to think about one in order to add efficiency.

Some franchisors are thinking about their current structure and whether or not there’s a business case for changes, such as shorter franchise agreements or a different fee.

Franchisors also should consider how this may impact their external metrics. Financial statement changes need to be communicated to investors, owners, private equity, lenders or even a management team with bonuses connected to earnings. If debt covenants are tied to EBIDTA metrics, EBIDTA in the current period obviously goes down when revenues are deferred. The new standard has been well-publicized, though, so it shouldn’t be a surprise to most lenders.

In addition, a new leasing standard is effective for public companies in 2019 and for private companies in 2020, under which lessees must put all of their leases on their balance sheet. This change will be even more impactful than the changes to revenue accounting. If companies need to talk to their lenders about the impact the new revenue standard will have on debt covenants, consider including a discussion of the new leasing standard, as it will be easier to address the impact of both at once.

Insights Accounting is brought to you by BDO USA, LLP

Revenue doesn’t always equal success in the eyes of investors

Startup companies that seek funding for growth are not the type of companies banks tend to see as the best candidates for loans.

“Banks know that most startups fail,” says Michael Stevenson, managing partner at Clarus Partners. “Startups and small businesses tend to have little capital at the outset and banks are leery of lending money that might not come back.”

Investors are experienced business people who are looking for specific metrics to determine a valuation. That often surprises most entrepreneurs who rely too heavily on revenue projections to generate a value.

Smart Business spoke with Stevenson about the importance of an accurate business valuation and what investors look for in early-stage companies.

Why does a business valuation matter?

For a startups looking for capital, a valuation determines the share of the company they have to give away to an investor in exchange for the money they need for growth.

There are three common valuation approaches: asset-based approach, market approach and income-based approach.

Asset-based valuations are based on the assets a company holds — real estate, inventory, or machinery and equipment, for instance.

Market approach uses proxies, which are comparisons of similar types of companies and what those have sold for in multiples of revenue or EBITDA.

Income approach uses a company’s historical or projected earnings to make assumptions about future earnings.

The income approach is the most common, but often two of the three approaches are used to determine a company’s value.

Who should perform a valuation?

Independent valuation companies and most larger accounting firms will perform a business valuation.

Accounting firms can help companies develop an investor deck that lays out its value, its growth history, key staff and their influence on the company, the market and direct competitors, competitive differentiators and strategies for future growth.

It’s usually the entrepreneur who has a valuation performed on his or her business. A potential investor will ask to see the assumptions used to make the valuation, typically looking at revenue, net income and gross margin growth.

Investors like to see valuations put together by experienced professionals as it gives credence to the numbers. CPAs are particularly valuable for this reason. Investors are more confident when they see that a CPA with experience making projections and modeling has helped the entrepreneur create a forecast. It can be beneficial to have that person on hand when pitching to investors to explain the numbers and how they were reached.

What numbers should entrepreneurs watch to get the most accurate sense of their company’s value?

Gross margin, net income and cash flow are the more important figures. Many startups think sales are the only measure, but if those sales don’t make any money, they don’t matter.

If a startup is seeking funding for more inventory, economies of scale suggest that buying more will drop material costs and improve gross margin. That’s often seen as a good investment.

But looking purely at a revenue increase and ignoring gross margin, which could go down and create ‘empty calories’ rather than generating cash, is a red flag and investors will balk.

How can advisers help business owners understand their business’ value and help improve it?

Most of the time business owners think their company is worth way more than the valuation, so an adviser has to explain how the value was calculated and how the owner can get to where they want it to be, often by devising strategies to increase profitability.

Before approaching investors, entrepreneurs should know their business and industry inside and out, have a realistic value of their business and understand that an investor’s primary concern is to make money. Otherwise, they’re in for significant disappointment when no one is interested in funding their venture.

Insights Accounting is brought to you by Clarus Partners